Opinions Investor's Corner John Gudritz's Investor’s Corner - Is it just another illusion of prosperity?
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Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
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The expression “illusion of prosperity” was used during the Great Recession to describe the last economic expansion. It is thought that most of the economic growth and wealth creation during 2003-2007 was based on the excessive use of debt to fuel price increases in real estate and in the stock market beyond what could be supported by actual personal incomes and sustainable business cash flows. When the debt bubble burst, asset prices tumbled and the tremendous wealth that had been generated during those years quickly vanished into thin air.
In this current economic recovery, the Federal Reserve is no longer just playing a supporting role as it did in the last one, but is taking the lead to try to recreate the wealth that was destroyed. With its zero interest rate monetary policy combined with two doses of quantitative easing it has intentionally tried to recreate the illusion of prosperity by forcing investors into riskier assets and pushing the stock market even higher.
With corporate earnings about to surpass 2007 highs, most people would take issue with my use of the word “illusion” to describe the wealth created over the past two years from higher stock prices. To me this wealth will remain only an illusion until the stock prices are supported by a sustainable economic growth rate or replacement asset values that warrant the current market valuations.
While in the past few months I was encouraged by some improving vital signs of sustainability, I am once again worried about a likely significant slowdown in the economy throughout the rest of this year. What has changed to create this apprehension?
First of all, possible oil supply disruptions from the spreading unrest in the Middle East have caused oil prices to rise to the point where gas prices are crossing the $4/gallon mark. In addition, food prices are heading upward as food producers are finally raising prices to cover the higher costs they have been experiencing for quite some time. The benefit to consumers from the payroll tax cut this year has been wiped out from these higher prices. As a result, economists are cutting their 2011 GDP growth forecasts.
Despite the acceleration in nonfarm payroll employment over the last few months, unemployment remains high so average hourly earnings of workers are not even keeping up with inflation. The continued rising gas and food prices only make it worse. It is no wonder that consumer confidence surveys declined to recessionary levels in March.
These sentiment surveys have been consistently lower during this recovery than in previous ones. It may have something to do with retirement worries among the 77 million Baby Boomers in this country. A recent poll by the Associated Press stated that 44 percent of boomers think they won’t have enough money to retire on. They will be more inclined to save than spend.
Additional bad news in March was the drop in home prices in January. The S&P/Case-Shiller Index of property values in 20 cities declined by 3.1 percent from January 2010, the biggest year-over-year decrease since December 2009. Prices in 19 of the 20 cities fell, suggesting widespread weakness. With an inventory of over 5 million homes either on or soon to be on the market, it is difficult to see a bottom in home prices soon.
Some of the fastest growing economies in the world like China and Brazil are now putting on the brakes in an effort to reduce inflationary pressures. This will reduce future export demand for U.S. products.
Last but not least, the state and local governments in the U.S. that represent 15 percent of the U.S. economy have been cutting spending and raising taxes more than what we thought was politically possible.
Investing in a cyclical bull market within a secular bear market when stocks are significantly above fair value is fraught with risk of sudden and substantial declines. This is especially true when the economy is in a deleveraging process with prices of assets that were borrowed against (real estate) still declining. That is why I am again so cautious.
Whether it is right or wrong at this time, the American people want their representatives in Congress to cut spending and start to pay off debt. That means no more additional fiscal stimulus to offset the shrinking private sector debt. In addition, the Fed will no longer be creating hundreds of billions of dollars with QE2 after June to support the stock market.
The economy is approaching the moment of truth where it will need to show investors that it can grow on its own and not falter like it did a year ago when QE1 came to an end and the impact of fiscal stimulus lessened. We will see if this recovery in the economy and the resulting wealth created are for real or, once again, just an illusion.